Sipp investors have been decreasing their exposure to higher volatility asset classes, but the long-term nature of these arrangements means many clients have adopted an approach that is too cautious
Once the preserve of a niche area of the market, Sipps are an increasingly popular recommendation by advisers.
The sophistication and flexibility that these contracts offer are clearly appreciated by clients and their professional advisers. In particular, the ability that Sipps give to advisers to employ a wide range of assets and fund managers has allowed them to more skilfully construct portfolios to suit income drawdown.
We have moved on a long way from the situation in which a portfolio had to be built from the limited range of funds available from one provider.
It is difficult to see how one house can accommodate all the needs of an investing client with a substantial pension fund to allocate. Having said that, there has been no place to hide in the awful bear markets of the last three years, and no matter how skilful an adviser has been, it is difficult to generate meaningful returns in these conditions.
Constructing a portfolio for an income drawdown client is difficult enough of course at the best of times. An exercise that involves a need to generate a given level of income (increasing over time) and at the same time preserve capital (or better) is asking a lot, even when markets are rising.
When one then takes into account the fact that this essentially long term plan has to be measured over three year time periods then the whole concept of drawdown looks questionable.
So what has been going on in terms of investment sentiment?
Predictably, investors in income drawdown products have become increasingly defensive in their attitudes and as a result deposit accounts and bond and property funds have taken much of the new business and tactical reallocation. As a general rule, the traditional default asset class of choice, equities, has been avoided. In as much as advisers allocate to equities, demand is largely for the equity income sector.
Why are these areas now so attractive? First and foremost, clients wish to avoid further losses. Cash especially is a safe haven and offers a moderate real return. As a short-term option this is attractive as a short-term option and advisers are happy to make the recommendation with the proviso that the planned review period is significantly reduced, from a year to three months for example.
Gilt funds have no default risk and are posting positive returns. While most observers remain confident that there is little inflation risk and equity markets stay weak no doubt support for Government bonds will continue.
Corporate bond funds do not have the same level of security but again attractive recent returns and the comfort of an inflation beating yield have been sufficient to attract many investors.
Despite the potential default risk, high-yield funds are heavily supported and the spread on BBB stocks and below is expected to tighten, so generating further gains.
Finally, property has maintained its position as the best performing asset class over three years. The intuitive appeal of a real asset has encouraged many advisers, bruised by the smoke and mirrors of equity investment, to tilt clients' portfolios towards property.
In combination with the reduction in value of equity holdings, this asset class has therefore become an increasingly large part of the average portfolio.
Equity income managers still receive support and their world view has certainly contributed to their relative success. By definition, the disciplines of generating a mandated yield have helped because it is those mature, profitable companies that have the free cashflow to generate dividends that have prospered in current market conditions.
No doubt the track records and reputations of the larger players in this sector have also contributed to their success.
The shift towards more defensive and less volatile areas of the market does beg a question however. Are we now as a profession too defensive? Are we taking enough risk?
There are many informed observers asking the same questions. The reasons for this are clear ' Sipp and income drawdown planning is usually for the long term. A contract put into force now may well be in play for 10, 15 or even 20 years. Clients have to look beyond the near term and plan ahead.
So if the time horizon is extended should this be reflected in asset allocation? Theoretically yes.
Even now, having taken into account the last three years, there is a strong statistical case for equities as the most appropriate long-term asset.
Understandably, clients wish to avoid the disappointments of recent years and the volatility of equity markets, but risky assets are also potential growth assets. The longer the time horizon, the more risk can be taken on. By avoiding risk in terms of volatility, are we increasing the risk of underperformance?
Some clients do not need to take much, or any, risk. For example, income drawdown clients seeking to draw minimum GAD may have little need for high performing assets in order to maintain their investment plan. But for others this is not the case.
An unduly cautious allocation strategy will impair total return over time. A more active and reasoned strategy will allow an adviser to add genuine value to a recommendation and improve upon the risk free return available from less volatile assets.
However the biggest challenge is in delivering a return greater than other product alternatives ' particularly annuities.
If a client can generate a guaranteed income of say 6% per annum, via this route then arguably the investment alternative should be required to beat this return. And to beat 6% per annum the investor needs exposure to risk. Therefore the investment plan will necessarily contain a significant allocation to equities.
In the real world, clients' requirements will extend beyond this theoretical investment model. This is because they have wider financial planning and estate planning issues which require attention and this is where the value of an adviser is shown to best advantage.
Whether a recommendation is good or bad depends on clients' expectations and there is much work yet to be done in terms of efficient benchmarking. When all markets are showing healthy returns everybody is happy.
But now we need to understand exactly what is being asked of a portfolio manager. When it comes to a highly individualistic and client-specific arrangement like a Sipp, and especially an income drawdown arrangement, a generalised benchmark is increasingly irrelevant.
The ideal starting point is a personalised benchmark that is designed in partnership with the client, so that he understands exactly what he is getting in terms of potential risk. And that means the risk of volatility, for better or for worse.
A personalised benchmark designed with the clients can help them understand risk.
Poor recent returns have caused investors to take too conservative an approach.
Lower risk asset classes are more popular for Sipp investors.
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